The Interview - Katherine Buck, Wayne Hummer Asset Management: "As the recovery plays out, stock-picking will once again be rewarded"
Katherine Buck, a managing director and portfolio manager for small-cap core equity strategies at Chicago-based Wayne Hummer Asset Management, believes that in an environment of rising US personal savings rates, lower-end consumables such as fast food may benefit, while big-ticket durables could languish as consumers take a breather from the leverage used to finance such purchases in the past.
HW: What is the background to your company and fund?
KB: Wayne Hummer Asset Management Company was founded in 1981 as the investment management arm of Wayne Hummer Investments, a Chicago-based broker-dealer established in 1931. Currently, Wayne Hummer Asset Management has USD1.4bn in assets under management and offers the Wayne Hummer Small Cap Core mutual fund. The primary managing directors of the firm are Dan Cardell, who is chief investment officer and Todd Doersch, who is head of product development.
The Small Cap Core fund was launched on December 8, 2008 with A and I share classes and focuses on US equities. Its objective is capital appreciation, and it seeks to outperform the Russell 2000 index.
The fund's strategy is to invest in securities the management team believes are undervalued in relation to factors such as earnings, growth potential, cash flow, asset value or industry peers, yet which also have strong long-term growth potential. The fund's management team consists of two equity research analysts, Matthew Betourney and Zachary Rosenstock, and myself, and the fund currently has USD5.5m in assets.
HW: Who are your main service providers?
KB: Wayne Hummer Asset Management uses Ernst & Young for all audit services. Legal counsel is provided to the fund by Thompson Hine, and Gemini Fund Services acts as transfer agent. The fund distributor is Northern Lights Distributors and custodian is First National Bank of Omaha.
HW: Have there been any recent key events such as fund launches or changes to the management team?
KB: The past year saw a number of very significant developments at Wayne Hummer Asset Management. In addition to my joining the firm last summer and launching the small-cap fund in December, the firm added some impressive talent including director of fixed income Bill Gregg, head of municipal fixed income Pat Morrissey, head of the financial services division Steve Bohn and chief investment strategist Melissa Brown.
In April this year the firm acquired a majority stake in Advanced Investment Partners, an investment management firm in Safety Harbor, Florida specialising in US equity strategies for institutional clients.
HW: How and where do you distribute the funds? What is the profile of your current and targeted client base? What is the split of your assets under management between institutional and private clients?
KB: The funds are distributed primarily through the financial advisors of Wayne Hummer Investments and the portfolio managers of Wayne Hummer Asset Management. We also offer the fund on a number of platforms including Schwab, TD Ameritrade, Smith Barney and UBS. Looking ahead, we also plan to distribute through third-party registered investment advisers and our institutional sales channel as asset levels and track record length allow.
The fund's current investor base is consistent with Wayne Hummer's overall clientele, of which 65 per cent consists of high net worth private clients (with investible assets of at least USD1m), 30 per cent affluent private clients (with investible assets of at least USD250,000), and 5 per cent institutional. With the acquisition of Advanced Investment Partners and the recent addition of talent with deep experience in the institutional arena, the firm intends to increase greatly its emphasis on institutional clients going forward.
HW: What is your investment process?
KB: The small-cap team does all the fundamental analysis and portfolio construction. In addition we utilise Wayne Hummer Asset Management's quantitative expert Huong Le to assist in risk analytics.
In general, we look to identify stocks that are undervalued in relation to the company's ability to generate solid returns (in the form of cash flow), with opportunities to either re-invest that cash flow at good returns or return the cash flow to investors. The valuation we place on a security is directly related to a company's growth prospects and what we would be willing to pay for that cash flow stream and still generate a strong return on our investment.
We spend hours reading SEC filings and developing our own financial models that include past and future income statements, cash flow statements and balance sheets. Many equity investors stop after looking at earnings and price/earnings ratios. We focus not only on earnings per share but also on the company's ability to generate cash, what that implies for the balance sheet in the future, and how that impacts equity holders.
Management interviews, preferably in person, are also an integral part of our process. While we don't need to trust management in order to invest in some extremely undervalued assets, in most cases we like to believe that management is capable and is taking the company in the correct direction to maximise shareholder return. We also use this time with management to delve deeper into details of how their business might perform under different upside and downside scenarios. We incorporate what we learn from them, in conjunction with our own expectations about the future, into our forward estimates.
Finally, we spend a large amount of time monitoring competitors and suppliers and doing independent analysis, including trade show visits, store visits and simply paying attention to the world around us. We think that being Midwesterners outside the New York mindset is a huge plus in this last case. I like to joke that many of my former colleagues in Boston have probably never been to Wal-Mart.
HW: How do you generate ideas for your funds?
KB: We put ideas through multiple filters before making the investment decision to include them in the portfolio. We use quantitative ranks and filters to restrict the 'hunting list' to a manageable level for our team. In general, we look for stocks that are either cheap on an absolute basis or cheap relative to their expected growth rates. By necessity, this quantitative filtering process relies on consensus estimates.
In addition, my total of 13 years' experience in the equity investments field prompts me constantly to consider all the companies in my investing history as possible investments based on where I expect future growth to lie. This can help us find ideas in areas where a stock might be undervalued but the consensus is dramatically wrong - which happens a lot in small caps.
Once an idea is generated using these methods, we will do increasing levels of due diligence, culminating with intensive proprietary expectations modelling and valuation work. In general, we look to include ideas that have at least 30 per cent upside within an 18-month to two-year time frame, with what we believe is minimal downside risk. If an idea makes it through all of these hoops, we will devise a price target on the upside as well as downside risk, and size the position accordingly.
HW: What is your approach to managing risk?
KB: We use Axioma's multifactor risk model and sophisticated risk management software analytics to measure and manage risk. To ensure we are aware of the portfolio's risk exposure and the magnitude of risk we are taking, we monitor risk factors - style and industry - and stock-specific risk, their contribution to active risk, and whether risks taken are compensated with expected active return
That does not mean we try to minimise risk. However, we look to keep about 70 per cent of the portfolio's risk at the stock-specific level, consistent with the focus of our research energy and effort. At the sector level, we will be overweight or underweight sectors within reason when we have a strong view about their expected relative performance. For instance, our current industrials weight is more than 500 basis points shy of the benchmark. Finally, we make sure we understand our factor level risks to be mindful of how those exposures might make the portfolio behave in various trading environments.
HW: How has your recent performance compared with your expectations and track record? Do you expect your performance or style to change going forward?
KB: Historically, my portfolios have tended to run with betas less than 1.0 due to a value- and growth at a reasonable price-oriented style. In last autumn's downturn, however, it seemed that all stocks converged to a beta of 1.0 and there was no place to hide.
While we had a very solid 2008 on a relative performance basis in our separately managed account product, my past performance during market downdrafts would have suggested much better relative performance in the throes of the market downturn than we experienced. While many peers underperformed during this period, I was not happy with only modest fourth-quarter outperformance in our separately managed accounts.
I expect that as the recovery plays out, stock-picking will once again be rewarded, particularly in our holdings where there is some level of financial leverage. The market fled from all forms of leverage in 2008, even when a company's operating model easily could support the degree of debt they had taken on. Our most indebted companies relative to their ebitda have been extremely volatile performers - we think they will shine as the economy improves.
In the future we will stick to our knitting and do what we have been trained for and enjoy doing - continue to search out undervalued stocks in relation to the underlying company's ability to generate solid cash flows and reinvest those cash flows in growth or return the money to shareholders. We believe that this is the best way to add value over medium- and longer-term market cycles. During short-term periods of extreme optimism, this style often suffers as we don't have exposure to speculative names.
HW: What opportunities are you looking at right now?
KB: When we put together our first portfolios for the firm in mid-2008, commodity-related stocks were very hot and looking over-owned in our opinion. Despite having a strong affinity for the natural gas sector on a secular basis, we avoided it last summer as we didn't see much if any upside but a lot of downside risk as the economy decelerated.
We were correct in our outlook as natural gas commodity prices and stocks corrected to levels where we saw a lot of medium- to long-term upside without much if any downside, and we have been adding to what we see as high-quality holdings in that sector. We are unsure about exact timing in the recovery of commodity prices, so we have focused on companies that are well hedged and have balance sheets that will get them through this period of uncertainty.
Another area in which we have put a lot of weight is the consumer discretionary area, specifically lower-ticket consumables such as fast food. While we believe consumer savings rates are headed higher over the next decade than in the past, the consumer will loosen their purse strings on some everyday luxuries such as a chili cheese dog and tater tots at Sonic. We are less optimistic about higher-ticket consumer durables, as we believe the consumer needs to take a breather from the leverage used to finance these purchases in the past.
HW: What events do you expect to see in your sector in the year ahead?
KB: Typically, smaller market capitalisation stocks tend to lead the market coming out of a recession. What is different this time is that small caps outperformed their larger-cap brethren in 2008, with the Russell 2000 down 33.8 per cent and the Russell 1000 down 37.6 per cent. I would attribute this to the lack of total meltdown-type events such as Lehman and Bear Stearns in the small-cap universe.
Thus it is difficult to say with confidence whether small caps will outperform large caps in this recovery. However, on an absolute basis small cap stocks look uncommonly attractive on most valuation metrics. As earnings growth improves, I would expect the small cap sector to show solid appreciation in the next 18 months to two years.
HW: How will these developments affect your own portfolio?
KB: We are committed to being an asset class representative product, and as a result remain close to fully invested at all times. Our goal is to outperform the small cap universe as represented by the Russell 2000 total return index.
We tend not to own the most speculative of names in the universe as our investment discipline is based on our measure of intrinsic value based on a company's returns and growth prospects. When speculative names outperform, our portfolio tends to suffer on a relative basis, but we are confident that our approach will produce superior returns over medium- and longer-term horizons as the most speculative names often flame out due to lack of returns to justify the growth story.
HW: Are investors' expectations moving towards capital preservation? If so, how do you deal with this?
KB: Certainly, many investors will look at their recent statements and wonder what happened to their money if they were invested in equities. While the knee-jerk reaction is to move to cash, Wayne Hummer's client relationship professionals have communicated with our clients to stress staying the course with a prudent asset allocation policy designed for long-term capital appreciation and risk control.
As part of as asset allocation policy, we have suggested to many clients that they actually rebalance their portfolios in favour of more aggressive asset classes such as equities. In particular, small-cap equities often produce superior performance in the months following market bottoms.
HW: What differentiates you from other managers in your sector?
KB: Investors in Wayne Hummer's small-cap product are investing with a manager with a strong history of small-cap investing but a small asset base. I have previously managed mutual funds close to USD1bn in size, and as assets increase it becomes difficult to size positions quickly and react to a changing landscape.
I also have the advantage of having built strong relationships with management teams and the brokerage community through 13 years in the industry. As an analyst at Fidelity Management & Research, I was the primary point of contact for many small-cap management teams with one of their largest shareholders and worked diligently understand their business models in depth. As a result I have been able to maintain those types of relationship even at a much smaller firm.
Of course, management dialogue alone guarantees nothing in the way of excess returns, especially in a post-Regulation FD era. I use conversations with management to gain a greater understanding of a company's strategy and business model in order to estimate the degree of operating leverage that exists. Combined with our proprietary expectations for the company's operating environment, we believe this gives us a better understanding of the earnings outlook for a given company than the consensus§.
Another factor that differentiates our management style from the pack is willingness to bypass a potential winner if we don't feel we understand the drivers well enough, because we don't want to take the downside risk involved in such a position. When you're competing against a benchmark as broad as the Russell 2000 index, there are no sins of omission that there would be when up against a more concentrated index. Conversely, owning a big loser can kill you as every position is large active overweight.
HW: Do you foresee problems in raising mandates from investors through 2009? If so, what factors that will drive investors back to your fund?
KB: Despite an extensive investing history and having managed a large mutual fund with solid results, my lack of a three-year contiguous track record is definitely a barrier to raising assets. Not surprisingly, I view this as a huge opportunity for investors willing to move past a box-checking mentality and do real research on my past returns and process.
Wayne Hummer Asset Management plans to expand its mutual fund line-up in 2009. While we are relatively less known than our competitors, we have the advantage of not having left a bad taste in anyone's mouth through poor relative 2008 performance. All our actively-managed equity products beat their benchmarks last year, something that most managers cannot claim.
HW: Are you planning any mergers or acquisitions this year, given the talk of further consolidation in the industry?
KB: While our near-term focus will be on integrating Advanced Investment Partners and further developing inroads into the institutional community, we will continue to search for acquisition candidates, particularly those with international and alternative investment capabilities.
HW: Do you have any plans for further product launches in the near future?
KB: We are contemplating launching a US large-cap mutual fund, as well as developing unit investment trusts and structured products as distribution vehicles for our fixed-income team.
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